I’m often asked about the benefits of tax loss harvesting and how this strategy can be used advantageously. In some circumstances it makes sense, however, I think this strategy is oversold. Let’s define these terms and take a deeper look.
Tax Loss Harvesting
Tax Loss Harvesting is a practice that can be executed throughout the year that involves selling poorly performing investments within your taxable accounts to generate capital losses and
reduce your taxes. Those proceeds would then be reinvested back into the market. The tax rules currently allow you to use these losses to offset an unlimited amount of capital gains. If all gains are used up, you can apply up to $3,000 per year of the remaining losses to other types of income, such as salaries and wages.
Cost Basis Churning
In order to calculate your loss (or gain) you need to know your cost basis. For the most part, cost basis is the price you paid to purchase an asset. For example, if you bought 100 shares of
an index fund for $100 per share, your cost basis is $10,000. Tax loss harvesting may also be considered cost basis churning because you are selling off an investment that is valued at a
lower cost than when you purchased it and purchasing another investment with the proceeds. This action results in a lower cost basis. The aim is that you would eventually have gains and a lower cost basis, likely, means paying more tax.
The Wash Sale Rule
Tax loss harvesting is not as simple as selling an asset at a loss and reinvesting the funds. You have to follow what is called the “wash sale” rule. This means you are not allowed to buy a
“substantially identical” security within 30 days before or after the sale that created the loss. It is an IRS rule that was created to prevent taxpayers from claiming artificial losses. That said, you can purchase another fund but it cannot be “substantially identical” if you want the tax benefit.
When To Consider Tax Loss Harvesting
If you believe the investment will continue to decline then you are better off selling your investment now than watching it all dissipate. Let’s say you paid $10,000 for a stock. It is now
worth $7,500 and you expect it will continue to decline. You will receive a capital loss of $2,500 in that year that can be used to offset gains or income. If you are in the 24% tax bracket, this
would save $600 (2500 x .24) in taxes. If the stock went all the way to $0, your tax benefit would be $2400 (10,000 x .24), but of course, you would have been better to sell it off before it lost all of its value.
High Tax Bracket
If you are in a higher tax bracket now than you expect to be in the future, then selling off the investment when it is at a loss results in tax benefits, which would be most beneficial when
you’re in a high tax bracket. For example, you are in the highest tax 20% bracket for long-term capital gains now. You expect to be in the 15% long term capital gains tax bracket in the future. You have $10,000 in losses. Therefore, tax loss harvesting will save you $2000 ($10,000 x .20) in that year and net $500 (($10,000) x (.20-.15)).
If these are short-term capital losses offsetting short-term capital gains and you are in the highest 37% tax bracket now and expect to be in the 22% tax bracket in the future, tax loss harvesting will save you $3,700 ($10,000 x .37) in that year and net $1,500 (($10,000) x (.37-.22)).
Step Up in Basis at Death
If you plan to keep the asset until you die, you benefit as well as your heirs. You get a tax benefit now from harvesting a loss and your heirs won’t pay tax in the future either. When you die, your heirs receive a step up in basis. If you lower your basis via tax loss harvesting any gains that you would normally have to pay in the future are negated by the benefit of the step up at death.
Your Investment Strategy Needs Updating
Perhaps you have been saving and investing but you do not have a comprehensive investment strategy and need to make changes. If that is the case, there is the opportunity to make the
changes and not only make improvements to your overall portfolio but do it in a tax advantaged way. You’ll benefit because you'll have a more robust investment strategy and saving on tax now allows you to use that money to grow it over the long term. In the previous example, you saved $3,700 in tax. If that money is invested for 20 years and earns 6% per year, it will grow to become $11,194.
When Tax Loss Harvesting Does Not Make Sense
Low Tax Bracket Now
If you are in a low tax bracket now, tax loss harvesting might not make sense. You want to consider your current tax bracket both for income and capital gains as well as what it might be in the future. Using this to your advantage is known as tax bracket arbitrage. It is pretty involved and this article gives several examples and goes into more depth about tax loss harvesting.
Poor Replacement Investment Performance
You risk that your replacement investment (to avoid wash sale rules) doesn’t perform as well as your original investment. For example, you sold off Tech Stock A at a loss and purchased Tech Stock B that continued to decline. While you will have more losses to harvest, your goal is to have investments grow over time with gains higher than the tax deduction you receive from losses. If you have a solid long term strategy in place for your investments it is hard to justify potentially missing out on market returns. This article looks at that in a different context but drives home the point that it is important to stay invested.
Cost Basis Reduction
Harvesting too much to lower your cost basis may bring it down so much that upon selling in the future, you are moved into a higher tax bracket. Let’s say you bought 100 shares of Tech Stock A at $100 per share with a total value of $10,000. You sell it at a loss of $7500 (($100-$25) x 100). You then buy it back after the wash sale window while it is still at $25 per share. This is your new cost basis. The stock then goes up to $200 per share. That would result in a $17,500 (($200-$25) x 100)) gain, which could put you into a higher tax bracket if you sold.
Tax Loss Harvesting Is Overrated
In my opinion, broad tax loss harvesting strategies, applied without nuance, is indeed cost basis churning. Sure there is ongoing debate about the effectiveness of tax loss harvesting, just ask Mr. Money Mustache and Michael Kitces about the topic. But given all these factors, not to mention the time and possible trading fees involved, my take is, tax loss harvesting is overrated. From my perspective, the benefits given a particular set of circumstances need to be compelling in order to justify the effort and risks. I’ve seen tax loss harvesting advertised as an ongoing “value add” but I see the advantages (and disadvantages) as more nuanced and personal.